Risk and return are two sides of the same coin.
How does risk impact asset allocation?
It is one of the most fundamental principles of investing that you have to accept a degree of risk in order to generate a reward in return, and that the greater the risk you take, the greater the reward expected in order to compensate for this additional risk.
Risk must be the guiding light when it comes to building client portfolios, and risk-return profiles are an essential consideration for determining a client’s asset allocation selection.
It seems that now more than ever before, an understanding of risk is a vital trait for a successful investor and for a successful adviser.
In different times, leaving savings in cash would still generate a reasonable rate of return. But with interest rates at rock-bottom, savers will have to look elsewhere to generate a decent rate of return, and this inevitably means taking on more risk.
What is investment risk?
Risk is the possibility of a ‘bad’ event taking place. In simplistic terms and in the context of investments, this means the risk of an asset falling in value and the asset owner losing money.
But that is not to say that all risk should be avoided. Risk is positively correlated to return and it is one of the key drivers of investment returns. Fortune favours the brave, as they say.
When you think about what can cause an asset class to fall in value, it becomes clear pretty quickly that there are a great many risks that investors need to consider.
There are some risks, known as systematic risks, which generally affect most asset classes in the investment universe. These include the risk of inflation eroding the real value of returns; the risk of investing in an illiquid asset that was liquid, but now can’t be sold quickly; the risk of interest rates rising or falling; and the risk that exchange rate movements reduce returns in the investors' local currency or cause a loss.
Then there are non-systemic risks which will impact one individual business, sector or geography and can therefore be reduced through diversification. These risks include the risk of company collapse, or issuer insolvency, for example.
Investors should also be aware of systemic risks, which is the risk that a business or market collapse could trigger the collapse of an entire industry or economy. This really is the doomsday scenario for investors, but one that we have seen signs of both in the 2008 financial crisis and more recently during the pandemic, but wholesale sectoral collapse has largely been avoided thanks to largescale state support.
Risks come and go depending on economic conditions and evolve over time. One very important risk at the moment is the risk that investors are losing value in real terms because they are over-exposed to cash when inflation is breaching the Bank of England’s 2 per cent target.